Wednesday, January 22, 2014

Into new woods - and - one thing the market has going for it...

Good news for the stock market: We're out of the woods. That is, we're, for the moment, beyond any major political risk stemming from budget and debt ceiling battles in the U.S. (I'm guessing Congress will concede the debt ceiling next month with little more than a whimper). We're also, in my view, just beyond the risk that the Fed tapering its bond purchases (AKA quantitative easing [QE]) will majorly roil the stock market---although a strong wind could push us right back into those woods. We're, thus, beyond any near-term recession risk ("strong wind" caveat applies there as well), and if the IMF has it right the global economy (Europe even) will pick up a little steam in 2014. So, Whew!!

Of course we can't forget what "out of the woods" essentially means---it means we've made it through a particular set of challenges. Perhaps, therefore, we should say we're out of the woods we were just in. And there's nothing about finding our way beyond one set of woods that keeps us from entering another. Which by the way we have.

While it'll be refreshing, if I'm right, to not be so focused on Congress (at least till we approach the mid-terms this fall) and the Fed in '14, our eyes will be straining to see through the forest of corporate earnings (reported and estimated), of interest rates rising in response, let's hope, to a growing economy, of market valuations worthy of close scrutiny (earnings will need to handily beat expectations to justify today's valuations, particularly when interest rates begin to rise) and of a number of other potentialities that, if I were to address each one, would put you to sleep (if I haven't already).

So I'll cut to the chase here and tell you what I see as one potentially big thing the stock market has going for it going forward: The fact that it's reached its present level while corporations worldwide remain perched atop trillions in zero-interest-earning cash. Companies have been able, either through cost cutting, accounting tricks or share buybacks---or all three---to report consistently improving earnings (justifying the bidding up of their share prices) for the past several years. Last year, however, was a year of multiple (as in price to earnings [P/E] multiple) expansion. Which means share prices grew at a substantially faster pace than did per share earnings. Now there's nothing horrible about that---as long as P/Es don't get ridiculously stretched (as they did in the late '90s), and as long as earnings growth accelerates a bit from here. Why is a pick up in the rate of earnings growth so essential at this juncture? It's because P/E multiples tend to contract during periods of rising interest rates. And multiples contract in one of two ways, as a result of rising earnings or of falling stock prices. Which takes us back to what I keep saying---for the stock market to withstand higher interest rates, higher interest rates have to come as a result of a faster growing economy.

Now, back to all that corporate cash. There are two schools of thought: The prevailing one among policymakers and Keynesian economists is, alas, (in my humble view) the wrong one---that consumption grows the economy. The other one, the correct one, says that production grows the economy---that, ultimately, we must produce before we can consume (read Goods Buy Goods). Which speaks volumes about one of the chief reasons why we remain mired in a historically slow recovery: it's that companies have been reluctant to invest in the research, development and, eventually, the production of new stuff---the kinds of activities that would grow the economy and put people to work. I'd love to explore with you why companies have, to this point, idled the fuel that would propel themselves and the global economy to greater heights, but that would take more time than you and I can spare at the moment (just think new regs, the probability of more new regs, and the threat of higher taxes). So, for now, suffice it to say that despite what I just alluded to, I suspect (or hope) that---barring the next Great Recession occurring anytime soon---companies are about to begin (ever so gingerly, alas) doing more than simply buying back their own stock with all that cash. Which, again, could do wonders for the economy, employment, and, ultimately, earnings growth and share prices going forward. Time will tell...